Joseph Stiglitz on The Fall of Lehman Brothers

Card: What caused the demise of Lehman Brothers?

Stiglitz:    It’s very simple.  What I said was that there were low interest rates and lax regulations.  The financial sector, mortgage tried and encouraged people to borrow.  And when you’re alone, there were 950 billion dollars of what I call mortgage [equity] withdrawals.  People were taking money out of their mortgages, out of their houses and spending much of that.  The low interest rates didn’t stimulate an investment boom and factories and things that would have made our economy more productive.  What happened was, there was a little bit of investment but in houses beyond people’s ability to pay.  They had innovation but there were innovations that were in effect intended to get around the kinds of prudential standards that had been the basis of the soundness of our system.  So, for instance, they were lending mortgages that were a 100%, in some case more than a 100%, they didn’t have to pay the interest that was due.  At the end of the year, they owed more money than they did at the beginning of the year, they said, “Don’t worry because the price of housing was going to go up and you would be wealthier.”  Well, what they were promising was a, what the economists would say is a free lunch and we say that there’s no such thing as a free lunch.  If it were true, they just, by buying a house and at the end of the year you would be wealthier, everybody would have done it and the system could have worked.  So, what made it particularly obvious that something was wrong was that while housing prices were going up and up, the income of Americans was not going up and up.  The media, the person in the middle, income was going down.  People at the bottom were getting worse off.  So you had an impossibility, you don’t need a Nobel prize to figure out that if houses are going up… prices are going up and incomes are going down, there’s going to be a problem.  You can’t spend more than a 100% of your income on housing and it was a gamble.  But it was a gamble which we’re fairly sure we knew what the outcome would be and that was the disaster that we’re seeing.  Now, what they did then was to take the mortgages, in the old days, a bank would originate a mortgage and then hold on to the mortgage, if it made a bad mortgage, it would [build] a consequence.  But there is a new innovation called securitization.  Securitization or not enabled the diversification of risk around the world.  But diversification had another problem and I… sometimes joked to the students in my class after I explained the advantage of diversification, ran down to Wall Street to make money and didn’t listen to the second half of the lecture.  The second half of the lecture was about the problems of diversification.  The problems of diversification, it creates a new information asymmetry.  The person originating the mortgage knew more about the mortgage then the person buying the mortgage.  You sold the mortgage to people all over the world.  We did it… we based it on the principle that a fool was born every minute, and we would find those fools anywhere in the world.  Globalization opened up a new opportunity to find new people to exploit their ignorance, and we found them.  The loses in Europe have been actually greater than in America, in the subprime mortgage area but this was all a house of cards.  So Lehman was one of the companies that was particularly exposed to having bought these mortgages, they repackaged these mortgages.  There were many other people involved in this scam, the [IB] believed in financial alchemy.  You know, in the old days, alchemy, you took lead and convert it into gold and you can’t do that, of course.  They believed they could take F rated subprime mortgages, borrowings by people, well beyond their ability to pay and engage in some magic of financial alchemy and convert it into A rated products that could be held in portfolios of pension funds, safe enough to be hold by banks, to be hold or held by anybody.  But of course, it wasn’t based on reality and there was some obvious problems that [IB] agencies were being paid by the people who are engaged in producing these complicated financial products that were so non-transparent that not even those who own them understood what was going on.  So, the reason Lehman Brothers went down is two fold, they owned a lot of these bad assets but also because the products were so non-transparent, because they’ve engaged in so much of this accounting gimmickry that no one had any confidence.  The financial markets are based on trust, you give your money today and you hope to get the money back with interest but if the people you give your money to, may walk away with your money, pay it to their executives in high bonuses and what you’re left with is a lot of rotten assets, you’re not going to have that same trust and what’s happened is has been the lost of that trust.  So no one wants to turn over their money to help Lehman Brothers because they said, “We don’t know what your assets are worth.” 

Joseph Stiglitz on The Fall of Lehman Brothers.

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